Question

A company's 5-year bonds are yielding 9.9% per year. Treasury bonds with the same maturity are yielding 5.25% per year, and the real risk-free rate (r*) is 2.00%. The average inflation premium is 2.85%, and the maturity risk premium is estimated to be 0.1 x (t - 1)%, where t = number of years to maturity. If the liquidity premium is 1.25%, what is the default risk premium on the corporate bonds? Round your answer to two decimal places.

Answer 1

Required Return on 5-year Corporate Bond = 9.9%

Calculating the default risk premium on the corporate bonds:-

r_d = r* + IP + DRP + LP + MRP

r_d = Required rate of return on -year Corporate Bond = 9.9%%

r* = real risk free return = 2%

IP = Inflation Premium = 2.85%

LP = Liquidity Premium = 1.25%

DRP = Default risk Premium

MRP = Maturity Risk Premium = (t-1)*0.1% = (5-1)*0.1% = 0.4%

where, t = number of years to maturity, t = 5-year bonds

9.9% = 2% + 2.85% + DRP + 1.25% + 0.4%

DRP = 3.40%

So, the default risk premium on the corporate bonds is 3.40%

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